Treasury Tuesdays

Let's start with the "super-long" view to get an idea about where we are in the big picture.

Prices meandered from 2003-2005 as money flowed into the stock markets. Traders had not reason to engage in a massive sell-off because inflation was under control. At the same time, there was no reason to rally because the economy was expanding. So sideways was the primary direction.

From mid-2005 to the beginning of 3Q 2006 the market sold-off big time, losing about 10%. Then the market rallied and sold-off again, bottoming at the beginning of 3Q 2007. This was the formation of a double bottom in the IEF chart. Starting in the 3Q of 2007 we get the credit crunch rally, as traders started to move into the government debt market in a big way. Hence the run-up from $80 - $92. Investors were looking for return of capital rather than return on capital. Since the topping of that rally (more on that in a minute) the market has sold-off, originally to the 50% Fibonacci level and now is working with the 38.2% level.



The P&F chart shows the market had a slightly downward moving bias from 2003 - 2007. Note this chart really shows the double bottom along with the strength of the credit crunch rally. Notice in the 2007-2008 rally that price moved higher and the sold-off by a few points, only to then move higher.



The year chart also clearly shows the credit crunch rally. Prices continually moved through previously established price levels and then sold-off to consolidated gains. Notice how prices used the 50 day SMA as support during this rally. Also note the timing of the sell-off -- the Fed's backstopping the Bear Stearns buyout. This event signaled the Fed was not going to let the market "self-correct" but instead the Fed was going to take an active role in the "correction". In other words, the bail-outs were beginning.



The 6 month shows the sell-off. Prices moved lower for three solid months, holding within a trend channel. Also note the shorter SMAs moved below the 50 day SMA in late April signaling a confirmation of the trend reversal. Also note that prices eventually dipped below the 200 day SMA which is typically bear market territory.



The three month chart is sending a very confusing message.

-- Prices are bunched around the 200 day SMA and have been for the last month or so.

-- The SMAs and prices are configured very tightly.

-- The 200 and 20 day SMA are moving higher whereas the 20 is moving a bit lower and the 50 is moving up a bit. In other words there is no clear signal about market direction at this point.

Treasury Tuesdays

Here's a question for you: "would it be a Bonddad post without charts?"



From Tuesday of last week through Friday we see the IEF -- the 7-10 year Treasury sector -- dropped continually. It continually moved through support and made new lows. The primary reason for this move was the stock market's rally. There are times in the market when stocks and bonds are inversely related; as stocks move higher they pull money away from the fixed income market. Last week was one of those times.



Looking at the 6 month daily chart, notice the IEF peaked in mid-March of this year and has been in a downward sloping trend/channel since. This also corresponds to a rally in the stock market. However, starting in mid-June the Treasury market caught a bid again largely as a result of safe haven buying. But last week prices dropped in reaction to the stock market.



On the three month chart, notice the following:

-- Prices are below the 200 day SMA

-- The 10 day SMA turned negative

-- The 50 day SMA is still heading lower, but at a smaller angle

-- The 20 and 200 day SMA are heading higher

-- Prices are below all the SMAs

-- Prices and SMAs are bunched up pretty tightly.

So -- the chart is giving some pretty mixed signals. The shorter SMAs are bearish but the longer SMAs are bullish.

Treasury Tuesdays

Let's go to (what else?) the charts to see what they're telling us this week.



Above is a 1 year chart of the 7-10 Treasury ETF. This part of the market rallied from the end of last summer to March of this year. The credit crisis started last summer, which was a natural stimulus for the Treasury market because of its safe haven status. In March of this year the Fed back-stopped the Bear Stearns deal which indicated the Fed was going to be far more open to the idea of intervention. This made Treasury bonds less attractive. However, over the last month or so we've seen a the Treasury market start to advance again.



Above is a three month chart of the 7-10 year Treasury market ETF. Notice the following.

-- Prices have moved above the 200 day SMA, indicating a move into bull market territory

-- The short term SMAs (the 10 and 20 SMA) are both moving higher

-- The 10 day SMA has just moved over the 200 day SMA

-- Prices are above all the SMAs

This is a chart in transition. Traders are obviously more confident about the future price prospects of the Treasury market -- or are more interested in the short-term safety of these bonds. Considering inflation is higher than we would like, the safety argument is probably the primary reason for the rally.



On the 6 day chart, notice the following:

-- Prices rallied from Monday until Thursday as the market fell.

-- The market formed a double top and then fell hard on Friday, largely as a reaction to the news of Freddie and Fannie. A federal bail-out means more government spending.

-- Prices rallied yesterday as traders realized the Fed plan might actually help.

Treasury Tuesdays

Some interesting trends developing in the Treasury market right now. Let's review what should move the markets and why:

1.) Inflation expectations are perhaps the biggest determinant of direction. Because bonds have a fixed rate of return, anything that lowers that rate lowers demand. Rising inflation takes away more of the money investors get from fixed income payments, so a period of rising inflation should lower the bid for bonds.

2.) Flight to safety: whenever things get really crazy, investors flock to bonds as a safe haven bid. This simply means that bonds have a specific payment investors can continually expect to receive from their interest rates. This is attractive when the overall environment is a bit nuts.



On the 7-10 year chart, notice the following:

-- Prices rose through mid-April. That was the result of the rally that started at the end of last summer. This rally was the classic "flight to safety" bid. As the financial markets dropped, investors flocked to the safety of the Treasury market.

-- Prices fell starting in mid-March. This was a reaction to the Fed's move to back-up the JP Morgan/Bear Stearns deal. This move sparked a rally in the stock market which means bonds would probably sell-off (which they did).

-- However bonds have risen since mid-June. The question is why? There are several reasons. First, it's become more and more obvious the Federal Reserve won't be raising interest rates anytime soon. This makes the current run of Treasuries more attractive because investors know that bonds with a higher coupon won't be coming down the pike. There is also the increase in overall volatility which makes the safe haven of bonds more attractive. However, what I find interesting is this is happening in a period of higher inflationary pressures. Theoretically, higher inflation should take the bid away from Treasuries. Instead we are seeing an increase in Treasury prices. I'm guessing there are two inter-related reasons for this. First, traders are expecting inflation to come down. The Fed has continually stated they see lower inflation ahead. In addition, yesterday we saw big drops in commodity prices adding fuel to the lower inflation fire. Secondly, the stock markets have been extremely volatile. This makes the fixed return of the bond markets very attractive.

Treasury Tuesdays

Treasury's are not the best market to be in right now:

U.S. Treasuries headed for their biggest quarterly loss in four years because of speculation the Fed will push borrowing costs higher later in 2008 to keep inflation in check.

Let's look at the 6 month charts to get a better picture of that is happening.







The short, medium and long end of the curve have all been dropping for a few months. The question is why? There are several reasons. First, all three parts of the curve rose in a big way in reaction to the credit crunch that started last summer. So the sell-off is simply a matter of profit taking. Secondly, the equity markets started rallying in mid-March. This rally competed with the Treasury market for funds and attention and won. Third, inflation started to become more and more prevalent:

Conflicting stories about inflation and growth will buffet markets this week and beyond, keeping bonds tied to ranges, with intraday swings, unless the credit crisis or the economy take a large turn for the worse. That would force central banks to shift their attention away from inflation back to growth -- an unlikely prospect this week, with the European Central Bank set to raise rates at its meeting Thursday.

Also remember this part of the Fed's statement:

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

So - why are all three Treasury sectors rallying right now -- and why have they broken through upper resistance? My feeling is the market thinks two things. First, there is a safe haven bid in the Treasury market from the recent market turmoil. Secondly, the Fed said they would probably act but didn't. The lack of action led traders to buy the market now.

Treasury Tuesdays

Let's start with the most important chart in the Treasury market -- the 7 - 10 year chart.



The middle part of the curve started rallying at the beginning of July. This was a flight to safety caused by the start of the credit crunch. Prices rallied until early March of this year when they started to move lower.



On the 3-month chart, notice the following:

-- Prices have moved below the 200 day SMA

-- The 10, 20 and 50 day SMA are all moving lower

-- The 10 and 20 day SMA has move below the 200 day SMA

-- Prices are below the 20 and 50 day SMA; prices are just above the 10 day SMA



The long end of the curve (20+ years), is a bit different. They consolidated from the end of November/beginning of December to mid-May of this year. That's when they fell below support and moved lower.



On the three month SMA chart, note the following:

-- Prices are below the 200 day SMA

-- The 10, 20 and 50 day SMA are moving lower.

-- The 10, 20 and 50 day SMA have all moved below the 200 day SMA

-- Prices are in a clear downward sloping channel

-- Prices are just above the 10 and 20 day SMA. But prices have used the 20 day SMA as a pivot point for the last few months.



The short end of the curse (1-3 years) really benefited from the credit crunch. They rallied hard for nearly a year as traders parked their money in short-term bonds.



On the short-tern SMA chart, notice the following:

-- Prices are below the 200 day SMA

-- The 10, 20 and 50 day SMA are all moving lower

-- The 10 and 20 day SMA have both moved below the 200 day SMA

-- Prices are in a clear downward sloping channel.

All of these charts have clear downward sloping channels that have been in place for a few months. All also have downward sloping short-term SMAs (10, 20 and 50 day SMA). The bottom line the Treasury market has been correcting for a few months and the charts indicate we're in for more of the same.

Treasury Tuesdays

Treasuries area still caught between their safe haven status:

Renewed banking trouble Monday sent investors scrambling to buy low-risk government debt, with shorter-dated maturities making the biggest gains.

The two-year note rose 8/32 point, or $2.50 for every $1,000 invested, to yield 2.512%. That is down from 2.641% Friday as bond yields fall when prices rise. The yield on the benchmark 10-year note fell below the 4.0% mark again -- a level just breached last week. It was yielding 3.971% Monday.

The advances helped government debt gain back some ground after suffering a rout in the past few weeks amid rising inflation worries, speculation over higher interest rates and a recovery in risk appetite.

But risk aversion returned Monday after British mortgage lender Bradford & Bingley warned about the outlook for 2008, and two major U.S. banks, Wachovia Corp. and Washington Mutual Inc. made management changes. That reminded investors that the credit-market crunch, while improved from the worst levels in March, is far from over.

Standard & Poor's downgrades of the counterparty ratings on three major U.S. brokers added to investors' worries, as the ratings firm said it expects Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Morgan Stanley to make additional writedowns.

"You are seeing a flight-to-quality bid into Treasurys again," said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG's private wealth-management unit in New York. "The credit market crisis isn't over. This is just a reminder of that. The market is repricing risk."

and inflationary pressures.

Crude oil spiked to new records around $139 per barrel, deepening a stock market sell-off and driving flows out of riskier assets into safe-haven Treasuries. However, a sustained acceleration of inflation pressures even in a period of weak economic growth could later prove negative for bonds, analysts warned.

However, looking at the charts you could argue that inflation fears are starting to win, with the flight to safety trade happening as events warrant.

Also remember that last week we saw Bernanke and Paulson jawboning the dollar. This implies that interest rates might be rising. And then there was this from Bernanke yesterday:

Federal Reserve Chairman Ben S. Bernanke said policy makers will ``strongly resist'' any surge in inflation expectations, delivering his clearest message yet the central bank is done lowering interest rates.

Bernanke played down the biggest jump in the unemployment rate in 22 years in May and said the risk of a ``substantial downturn'' receded in the past month. Policy makers will need to pay ``close attention'' to make sure the increase in commodity costs doesn't pass through to broader consumer prices, he said in a speech to a Boston Fed conference late yesterday.

The Fed chief's remarks spurred investors to bet that officials will raise rates later this year and sent two-year note yields to their highest level since January. Bernanke and his colleagues are raising the alarm on inflation after oil costs doubled in the past year and companies from Dow Chemical Co. to tire-maker Titan International Inc. raised prices.

The short end of the Treasury market bounced between a narrow set of points from Tuesday of last week to Friday. However, the short end sold off yesterday.



The 7-10 year part of the curve is caught between two points. This a trading range which indicates traders are still caught between several conflicting interpretations of the markets.



And the 20+ year area of the market is still moving between interpretations as well.



Looking at the short end's daily chart, we see the following:


-- Prices have been in a downtrend since a little after the beginning of the year. This is a sell-off that came at the end of the fight to safety from last year.

-- Prices have just moved below the 200 day SMA

-- Prices are below all the shorter SMAs

-- All the shorter SMAs are moving lower

-- The shorter SMAs are below the longer SMAs



On the 7-10 year chart, notice the following:

-- Prices are bouncing around the 200 day SMA, but haven't made a firm move either above or below.

-- Prices are below all the shorter SMAs

-- All the shorter SMAs are moving lower

-- The shorter SMAs are below the longer SMAs

-- Prices have been in a confirmed downtrend since the beginning of the year



In the 20+ year market, notice the following:

-- Prices have moved below the 200 day SMA

-- Prices are below all the shorter SMAs

-- All the shorter SMAs are moving lower

-- The shorter SMAs are below the longer SMAs

-- Prices have been in a confirmed downtrend since the beginning of the year

The yearly charts show we are at/near a crossroads.



The short end of the curve has been declining for awhile and prices are right at the 200 day SMAs.



The IEFs (7-10 year) have also been declining since the beginning of the year and have been bouncing around the 200 day SMA



The TLTs have broken their trading range -- which they had been in since late last year -- and are firmly moving lower.

Treasury Market Roundup

It wouldn't be a Bonddad entry if I didn't mention something about charts. So, let's see what they say.



The short-end of the curve started to rally at the end of last summer. This was largely because Treasuries are seen as a safe investment. As the credit markets were melting down investors become worried about return of capital rather than return on capital. That's why they bid up the short end of the Treasury curve. But the credit markets have started to thaw a bit and people have started to move money back into the market which has dropped Treasury prices. Note the SHYs are approaching crucial support at the 200 day SMA.

Also regarding the SMAs, notice the following:

-- The shorter SMAs are below the longer SMAs

-- All the shorter SMAs are moving lower

-- Prices are below the SMAs, which will further lower the SMAs

These are bearish developments on the chart and indicate further declines.



The mid-section of the Treasury curve rallied along with the short end of the curve at the end of last summer. Note the solid rally. There is a solid trend line and prices moved higher and then sold-off back to the trend line. But this section of the Treasury market has also sold off starting in early May, and has really had a downhill move as the markets have risen. This indicates money is simply moving from the Treasury market to the stock market. As with the SHYs, notice the market is right around the 200 day SMA, marking the line between bull and bear market.

-- The shorter SMAs are below the longer SMAs

-- All the shorter SMAs are moving lower

-- Prices are below the SMAs, which will further lower the SMAs

These are bearish developments on the chart and indicate further declines.



On the TLT's notice the long part of the Treasury market has been trading in a range since the end of last year. Also note it has recently broken through support of that trading range. Also note the following:

-- The 10 and 20 day SMA are both headed lower

-- The 10 and 20 day SMA just crossed below the 200 day SMA

-- The 50 day SMA just went negative

-- Prices are below the 200 day SMA (bear market territory)

-- Prices are below all the SMAs

The bottom line with all the chart is for further declines in the Treasury market.

Treasury Market Roundup

On the weekly 30-year yield chart, notice that yields are in a broadening pattern, moving between 4.20% and 4.60%. Also notice the yields have broken through resistance that started with the flight to quality at the end of last summer. The question now is will yields go higher or stay in this area.



Notice the exact same situation with the 10-year -- that yields have broken through resistance that started at the end of last summer with the flight to quality. As with the 30-year, the question now is where will yields go from here.

Inflation is starting to take a toll on investors attitudes about government debt:

Inflation worries driven mainly by surging oil prices mean government-bond markets across the developed world may be in for a rough period.

Bonds are being weighed down by views that rising price pressures mean not just a halt to interest-rate cuts in the U.S. and the U.K. Concerns also are emerging that price pressures could force the Federal Reserve and the European Central Bank to raise borrowing costs later this year.

To be sure, the recent heavy selloff that has pushed yields higher may attract bargain-hunting investors. Disappointing economic data may also encourage some buying. But a more consistently upbeat tone may not be found until later this year, when growth might slow to a point that will push inflation worries to the back burner.

"We still see yields being pushed higher in the short term," said Cyril Beuzit, head of interest-rate strategy in London at BNP Paribas SA. "We need to see better news on the inflation front, or commodities prices fall a bit, or a significant setback in [stocks] or very weak data in the U.S. before the bond markets turn positive again."

But investor's risk appetite is also starting up a bit:

The $750 million sale Tuesday of bonds backed by auto loans to risky borrowers signals subprime isn't necessarily a bad word in the credit markets.

Deutsche Bank AG and Credit Suisse sold bonds backed by subprime auto loans issued by AmeriCredit Automobiles Receivables Trust, which increased the size from the $500 million planned, as buyers, mostly money managers, bid aggressively. The demand knocked risk premiums down 0.05 to 0.15 percentage point below expectations. "There's still a lot of money out there. And, this opens up the potential for deals with similar risks," said Derrick Wulf, a senior portfolio manager at Dwight Asset Management.

Many investors in the $2.5 trillion asset-backed securities market, where consumer debt is packaged into tradable bonds, viewed the AmeriCredit offering as a litmus test for risk appetite. The offering paired subprime debt with bond insurance -- two of the biggest casualties of the credit crisis. Financial Security Assurance is insuring the offering to give it a triple-A rating.

However, notice that total asset-backed paper is still dropping right now:



And while the Ted Spread has dropped, it's still pretty high:



And while 1-month libor is coming in a bit, 3-month libor is still wide indicating the short-term market still has some problems.

Treasury Tuesdays

Here are the charts



The long-term chart clearly shows the flight to safety that happened as the credit market tightened. Notice how yields dropped big time as this happened. Right now yields have formed a flag pattern as traders wait to see what the next move will be.



Notice the same thing with the 5-year yields -- they dropped as traders bought the Treasury market in a flight to safety. Also notice how yields have started to move higher.



The 10-year Treasury also shows the flight to quality and the subsequent move away from the 10-year. More on this below.

Let's start with the good news. There is growing speculation that moving out of Treasuries and into higher-yielding, risker assets is the standard plan of managers:

Emboldened by economic data signaling a strong likelihood the Federal Reserve will keep rates on hold for now, investors will continue to move into higher-yielding and riskier securities, including corporate and emerging-market debt. Global bond-fund managers may also consider selling short-dated Treasurys and buying government debt of similar maturities in Australia and New Zealand to pick up extra yield.

"That is where the opportunity is: putting on a bet that the fed-funds target rate is going to stay at 2% or lower for a much longer period of time," said James Kauffmann, head of fixed income for ING Investment Management in Atlanta, which oversees more than $40 billion of institutional and mutual-fund assets.

Friday's better-than-expected payrolls report supported the notion that the Fed can retire to the sidelines for now, and government bonds ended sharply lower across the board. But the shift in the market's rate outlook has been under way for several weeks, as the state of the economy has appeared less dire than had been feared. The Fed's liquidity-pumping measures -- which were tweaked again Friday -- have also helped reduce fears of a market meltdown.

Treasuries are also getting competition from a rush of new corporate issues:

On the corporate bond front, U.S. investment-grade companies are likely to issue another $80 billion to $100 billion in new debt in May after a surge of debt offerings in April, Bank of America said in a note released Thursday.

According to Thomson Reuters, companies with high-grade credit ratings issued $117 billion in bonds, the second best month ever. Some $40 billion bonds got underwritten during the week of April 25 alone.

This is a big reason why Treasury yields have moved higher over the last few weeks. Traders have sold Treasuries to move into higher yielding assets and equities. In other words, the flight to safety is starting to ease.

Also adding some upward pressure on yields is the Treasury is trying to figure out how to finance a growing deficit:

As the federal government rolls out its economic-stimulus plan, the Treasury market is eyeing the return of one-year bills and three-year notes to help offset the government's deteriorating fiscal outlook.

Changes to the maturities of debt sold by the government could be announced as early as Wednesday, when the Treasury presents its quarterly refunding program.

But given how low yields currently are on low-risk government debt, these two maturities might be a hard sell.

Yields on Treasurys with maturities of 10 years or less are below the current 4% inflation rate, and returns on government bonds are set to be negative in April for the first time this year.

Remember -- the government is bleeding debt right now. And the latest "stimulus" plan will only make matters worse. Somebody will have to pay for this. And its looking like we're going to ask future generations to pay rather now. At some point, this increased borrowing will lead to higher rates. The question is simply when will that occur.

LIBOR is still an issue indicating that the credit markets are not well.

A major source of stress has been the London interbank offered rate, or Libor, a benchmark for the rates banks pay on dollar loans in the offshore market. It remains unusually high compared with expected Federal Reserve interest rates, an indication that banks continue to hoard dollars.

Central banks have already taken steps to ease European banks' dollar-denominated funding needs, but the resurgent tension has policy makers discussing whether the current arrangements are enough.

There are disagreements about why the rate is rising. Fed officials attribute the recent Libor rise to European banks' needing to borrow in dollars, because the pressure tends to slacken around midday in the U.S. when the European day ends. U.S. banks have tended to retain their dollar holdings until the end of the day in New York, making it even harder for overseas banks to obtain dollars.

European officials aren't convinced demand from European banks for dollars is the source of the trouble. Since March 11, the amount on offer at ECB's swap line has been a relatively modest $30 billion. In each of three $15 billion auctions it has held since then, demand hasn't been overwhelming, suggesting to some European officials that European banks aren't desperate for dollars. The ECB also saw prior global central-bank maneuvers as partly a symbolic effort to try to calm markets.

On Saturday, Barron's outlined the tools the Fed has used in its effort to lower LIBOR:

Libor has remained stubbornly high, at 2.815% for the key three-month maturity. That's higher than it stood before the Fed's previous rate cut, to 2.25% from 3%, on March 18. In other words, the central bank's actions haven't affected much of the real world.

To counter that, the Fed announced it would boost several of its new policy instruments designed to funnel liquidity to the borrowers needing it most. Specifically, the Fed will expand its

Term Auction Facility by 50%, to $75 billion per auction, for a total $150 billion.

The Fed also said it would boost its swap lines to foreign central banks -- to $50 billion from $30 billion for the European Central Bank and to $12 billion, or doubled, for the Swiss National Bank -- to provide the wherewithal for those central banks to lend dollars to banks having difficulty borrowing.

In addition, the Fed said it would expand the collateral accepted at its Term Securities Lending Facility, which allows dealers to swap less-liquid securities for good-as-cash Treasuries, to include triple-A-rate asset-backed securities.

Treasury Tuesdays

The bottom line story of the last few weeks in the credit market is traders are moving into riskier areas of the bond market.

The major U.S. indexes have been rallying since hitting a trough in mid-March. The difference between corporate bond yields and ultra-safe Treasurys has narrowed, as has the spread between mortgage agency bonds and Treasurys. And the cost of buying a type of insurance against corporate defaults has plunged.

While the previous points are good news, they look an awful lot like bottom fishing by money managers to me. They are less indicators of intra-credit market sentiment and more indicators of speculative sentiment. As a result, I still think the LIBOR issues are troubling as the represent what banks are thinking -- especially about each other. And increasing LIBOR rates indicates banks are still concerned about other banks ability to repay loans.

Same point, different article:

Investors are turning to riskier investments that had been all but abandoned earlier this year, such as corporate bonds, where last week a record $40.1 billion in new debt came to market, including issues from embattled companies such as Citigroup Inc. and Merrill Lynch & Co. Meantime, the premium that investors are demanding on corporate debt -- even low-quality speculative grade, or "junk," bonds -- is coming down as fears subside.

"We established that the Fed was going to backstop the markets, keep things stable and slowly but surely nurse the markets back to health," says Daniel Shackelford, a portfolio manager at T. Rowe Price Group Inc. As a result, "risk-taking has come back in the market."

Another article made the same point:

While they are diving into riskier corporate debt, investors have been pulling away from safer Treasury bonds, especially among short-term securities most sensitive to Federal Reserve policy.

Many now believe that when the Federal Open Market Committee meets Tuesday it will lower the benchmark federal-funds rate by a quarter of a percentage point to 2% but will signal a pause in additional moves until the economic outlook becomes more clear.

The recent selloff in the market for Treasury bonds was fast and furious. Yields on U.S. Treasury two-year notes rose to 2.42% Friday from 2.17% the week before and substantially above the 1.33% low hit on the day after the Bear Stearns deal was announced. Yields rise as bonds' prices fall.

Mortgage-backed bonds, one of the hardest-hit corners of the market, also have improved, especially those backed by government agencies Fannie Mae and Freddie Mac. The spread on these bonds has narrowed by almost a full percentage point from March levels.

In the market where investors buy and sell insurance against corporate defaults, fears of a financial institution collapse also are abating. Insurance against default on $10 million of Merrill Lynch debt for five years now costs $167,000 annually, down from a high of $335,000 in mid-March, though it is still much higher than it was last June, when it was $25,000, according to pricing service Markit.

In the short term treasury market, notice the upward trend of last 6 months has been broken. That means traders are more comfortable with what is happening in the credit markets overall.

The short end of the Treasury curve was not the only part of the curve to see some selling. The 7-10 year also experienced some selling:



The 7-10 year area of the market has clearly seen some selling as well, as it has also broken an uptrend.



And the 20+ year is in an obvious trading range.

But we know that all is still not well in the credit markets, as LIBOR is spiking again:

An interest-rate based on what banks charge each other for loans has risen in the last week, sidestepping a general improvement in credit sentiment and acting as a reminder of the still-severe hurdles facing U.S. banks.

The London inter-bank offered rate, or Libor, has risen 23 basis points since April 1 to 2.91%, according to three-month U.S. dollar Libor rates quoted by FactSet Research. It's risen 33 basis points since mid-March, when several other market indicators instead started to show signs of improvement. One basis point is 1/100th of a percentage point.

"The stress in the money markets is still acute," said BNP Paribas economist Gizem Kara and colleagues in a note Thursday.

A higher Libor rate means banks are charging more for short-term loans to each other, suggesting they are more nervous about the borrowers' ability to pay back. It may also indicate banks, struggling with billions in bad loans, are hoarding capital and less likely to loan to each.

There were two auctions last week. Last Wednesday's auction went well:

Yields on two-year Treasury notes held near an almost two-month high after the U.S. sold a record $30 billion of the securities, indicating investors are more willing to buy debt even as expectations fade for interest-rate cuts.

The notes were sold at a yield of 2.225 percent, below the 2.2336 percent average estimate of nine bond-trading firms surveyed by Bloomberg News. The group of investors that includes foreign central banks bought a bigger share than their average over the past six auctions.

Indirect bidders, the category that includes foreign central banks, bought 33.6 percent of today's sale, the most in seven months. At the past six auctions, the group bought 23 percent on average.

That makes the horrible result of Thursday's 5 year auction that much more important:

``It was a horrible, horrible auction,'' said David Ader, head of U.S. government bond strategy in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 20 securities firms required to bid at Treasury sales. ``An auction result like this is going to push people to say, `I'm going to step aside.'''

At today's sale, the biggest since February 2003, the bid- to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was $1.65 for every $1 sold. That was the lowest since February 2003, and down from $1.98 in March.

Indirect bidders, a group of investors that includes foreign central banks, bought 29 percent of the securities, down from 34 percent in March.

Traders pushed two-year note yields to the highest level since Jan. 18 on speculation the central bank won't lower borrowing costs further after this month. The losses pushed the securities' yield above the Fed's benchmark rate by 14 basis points, the most since June 2006.

Remember -- the US government is bleeding debt right now (and will be for the foreseeable future). Consider the following:

The Treasury's deficit for the month of February totaled $175.6 billion, making for a fiscal year-to-date deficit of $263.3 billion -- up 62 percent from this time last year. Outlays are on the rise, up 10.2 percent year-to-date and reflecting rising spending on defense and higher interest payments, which are a result of the rising debt. Receipts are up this fiscal year, but only by 1.3 percent. Individual income taxes are barely higher and corporate taxes are 15 percent lower. Rising spending and falling receipts, and the risk that receipts will fall further as the economy weakens, are making the budget deficit a bigger and bigger issue for the economy and for the value of the dollar.

One of the main reasons for the decline in foreign interest is the slumping dollar:

The Japanese, who own $586.6 billion, or 12 percent of U.S. government debt, had their worst quarter in Treasuries this decade, losing 7 percent in the first three months of the year as the dollar fell to the lowest since 1995 versus the yen, Merrill Lynch & Co. indexes show. Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co., three of the nation's four-biggest insurers, would rather accept the world's lowest bond yields in Japan than buy U.S. debt.

``It's too early to say the dollar will stop falling,'' said Masataka Horii, head of the investment team in Tokyo for the $53.1 billion Kokusai Global Sovereign Open, Asia's biggest bond fund. ``The U.S. economy will be slow for a while.''

Japan owns more Treasuries than any other nation. After raising their holdings by $9.2 billion to $620.6 billion between March and July 2007, Japanese investors trimmed that stake by $34 billion through February, the Treasury said April 15.

America relies on foreign investors, who own more than half the U.S. government debt outstanding, to finance a deficit that New York-based Goldman Sachs Group Inc. predicts will expand to a record $500 billion for the year ending Sept. 30, after a $163 billion gap last year. Without their support, long-term interest rates would be 0.9 percentage point higher, a 2006 Federal Reserve study found.

In Thursday's market summary, IBD noted that inflation concerns were taking their toll on prices:

With oil prices approaching the $120-per-barrel mark and soaring food costs, worries about inflation hit the longer end of the bond market. The benchmark 10-year Treasury note yielded 3.74%, up from 3.71% late Tuesday.

Longer-dated bonds are among the most sensitive investments to inflation expectations, since rising prices diminish the cash flow from fixed income and erode the overall value of the investment over time.

"The market is worried about inflation — that seems to be new story," said Thomas di Galoma, head of government trading at Jefferies & Co. in New York.

The market is not the only one worried about inflation -- the Federal Reserve may actually be more concerned about that now.

The Federal Reserve is likely to cut its short-term interest rate by a quarter of a percentage point next week -- but then may be ready for a breather.

The Fed, meeting Tuesday and Wednesday, is likely to make what would be its seventh cut in eight months. The reason: Some officials see a case for more insurance against a deeper recession.

But others are concerned a cut could contribute to inflationary pressure with little benefit for growth. That means the option of standing pat will likely also be on the table. If it does cut rates, the Fed could signal in the statement accompanying the decision an inclination to pause and assess the impact of its cuts, which have lowered the federal-funds rate to 2.25% from 5.25% since last year.

Officials say the case for lowering rates further rests primarily on the value of additional insurance against a worse-than-anticipated economic scenario.

Here are three charts of the year over year change in three inflation levels -- CPI, PPI and Import prices.



The year over year change in CPI is hovering around 4%.



PPI's annual YOY change is running at around 7%.



Import/Export prices are increasing to 8% YOY.

So, we have the following points to keep an eye on.

-- Inflation is heating up and will probably impacting bond traders sentiment for some time

-- Because of a high deficit, there will be a big supply of Treasury bonds hitting the market. Increased supply means there will probably be upward pressure on interest rates

-- There is growing speculation the Fed is nearing the end of rate cuts. That may lead to increased rates as well.

-- Traders are selling Treasuries and moving into riskier assets.

Why Isn't the Bond Market Selling Off From Inflation Fears?

While the 20+ year end of the Treasury Market has dropped below its year-long trend line, it isn't selling off that hard.



The 7-10 year part of the market is also still clearly in an uptrend.



The short end is still rallying as well.

Let's review what moves the bond market.

1.) Interest rate policy. When the Fed is lowering rates, previously issued bonds (which have a higher coupon) are more valuable. This means investors will buy them, increasing prices.

2.) Safety: In times on uncertainty, investors seek safe havens. That means government bonds.

So -- we have two strong reasons for the Treasury market's rally over the last year. But

3.) Inflation eats away at the interest rate received by bond investors.

Considering we've had some really nasty inflation reports lately, the bond market should be selling off, right?

Maybe not. While I am still extremely worried about inflation, my friend New Deal Democrat is not. He offers the following chart and explanation as to why inflation is not a problem.

Below is a graph showing how inflation tends to play out over economic cycles. The blue line is consumer inflation (cpi). The red line is producer inflation (ppi) which is the rate at which costs are increasing to producers. The green line is household debt.

A regular pattern of cpi vs. ppi inflation unfolds over economic cycles. Consumer inflation is relatively tame, but consumer inflation starts out very low, and considerably less than consumer inflation (the red line is under the blue line). Simply put, producer costs aren't rising as fast as consumer prices can be increased, and increased production and sales leads to increased profits. Over time, both consumer and producer inflation increases. Ultimately, producer prices increase faster than consumer prices.(the red line is over the blue line). Producers aren't able to pass on their increased costs to consumers, and their profits decline. When their profits decline, they cut back and lay off employees. A recession ensues as consumers pull in their belts. Prices, especially producer prices, decline, thus setting off the next cycle.

In the graph above, you can see that just before every single recession, both the red and blue lines are going up, and the red line has overtaken the blue line. In other words, producer prices are rising, and have overtaken consumer prices. When the recession hits (the shaded area) both the red and blue lines decline, meaning that both consumer and producer inflation are decreasing.

Thanks to NDD for letting me use his piece.